26 September 2011

Alternative investment funds AIF regulations - Finsec comments

Our firm, Finsec Law Advisors submitted the following comments on the concept paper/draft regulations of SEBI on Alternative Investement Fund regulations (AIF), which were proposed last month.We  also submitted para by para responses - if you would like our complete response, please send me an email and I will share the comment letter.

Regulating alternative investment funds is an important step within SEBI’s remit. Broadly, SEBI regulations must pass a cost benefit analysis and in line with that, SEBI has till now used light touch regulations where the investors are sophisticated and can thus take care of themselves. The concept paper recognises how important the industry is and talks highly of the 'patient source of active capital' which 'plays a very important role in the growth of the corporate sector' and that the capital brings 'a lot of governance and good quality money'. It is therefore important that the regulations sought to be imposed by SEBI should further the object sought to be achieved and such object be achieved keeping in mind a cost benefit analysis which is commonly termed as regulatory impact assessment. This analysis is done by most developed regulators in the world including the International Organization of Securities Commissions (IOSCO) as also by SEBI. 

The three goals of the regulations as stated in the concept paper itself are (a) management of systemic risk (paragraphs B.5 and 6), (b) targeting of benefits to certain types of funds and putting investment restrictions (paragraphs B.1 and 2) and (c) addressing conflict of interest (paragraph C.1)  

With respect to the first goal, while noting international developments, SEBI has not addressed the issue. In any event, as far as domestic private equity or venture capital is concerned, there is virtually no leverage or debt involved and therefore addressing the issue from a point of view of systemic risk is unnecessary. At the same time foreign investment vehicles may be highly leveraged, and the impact of such leveraged funds needs to be seen from India’s systemic risk perspective. This, SEBI needs to address along with RBI.

With respect to the second goal, the concept paper and the draft regulations seek to create investment silos and imposes restrictions on where each type of fund may invest. This takes away the only free lunch available in the financial markets — of diversification in different types of companies. Thus, a fund which wants exposure in SMEs, early stage companies and listed companies would be prohibited from investing unless they create three different pools. In our view, creating these silos would impose a severe cost not only on the players in terms of lack of flexibility, but such a system would inject higher risk on the investors. Thus to create silos to target benefits is inappropriate. Instead, it would be useful to make such silos optional, so anyone seeking a benefit can be recognised and avail the benefits.

The proposal seeks to mandate the types of companies which are kosher for a particular fund, including whether investment should be in listed or unlisted debt securities. There is a provision for the fund size to be a minimum of Rs. 20 crore, the minimum investment per investor to be 0.1% of the fund size. Then there is a requirement that funds be close ended with a minimum tenure of five years. VC funds cannot hold more than Rs. 250 crore in a single pool and cannot invest in companies promoted by the top 500 listed companies or their promoters. VC funds cannot invest in warrants or convertibles or even in listed debt securities (today a large number of VC funds are invested in convertibles). Private investments in public equity (PIPE) funds cannot invest in companies which are listed on exchanges that form part of any exchange index. PE funds cannot invest in listed shares. Debt funds cannot invest in listed debt securities. Why a regulation should mandate investment in unregulated unlisted debt securities is unclear, when listed debt is a more regulated and secure asset. None of this is useful and serves any regulatory benefit to investors or to the system.

Besides the investment micro management, there are other issues too. With respect to the third goal, the concept paper seeks to mandate minimum investment of 5% by the manager of the pool. This would make many smart managers to go out of business if they cannot shell out so much capital. Clearly, in the industry, what is needed is smart managers who can add value to the economy, rather than rich managers who may or may not be smart. The philosophy behind managers investing in the funds that they manage is to create alignment of interest. This alignment has been elsewhere termed as 'conflict of interest' in the concept note. Thus the 5% minimum investment by the manager ends up mandating a minimum conflict of interest (as per its definition). If at the end of the tenure any investments are un-liquidated, they are required to be taken up by the manager/sponsor. This is also dangerous, if there is a financial crisis and the securities cannot be sold at a reasonable price, both the sponsor/manager and investor would be hit by a regulator mandated fire-sale and by a mandatory underwriting by the manager. There is, therefore, a premium on rich managers and a regulatory exclusion of smart managers — a regulatory self-goal. SEBI needs to seriously relook at these proposals."

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